The commercial mortgage-backed securities (CMBS) market floated approximately $30 billion in new issues in 1996 and may do so again in 1997. Thus, securitized sources of mortgage finance are supplying a much larger share of all commercial mortgage originations than they did just a few years ago. This article explores what impacts this greater use of CMBS will have upon commercial property markets.
Direct effects of more securitized mortgage finance Using more CMBS financing has several direct effects different from former use of traditional mortgage lending from banks, insurance companies and other established lending sources. First, it increases the number of different capital suppliers putting funds into commercial mortgages. Many lenders have in the past avoided making commercial mortgage loans, because they did not believe they could properly underwrite such loans since they do not have specialized real estate staffs. Now many are willing to buy CMBS if the latter have received investment-grade ratings from rating agencies.
This greater number of fund sources more broadly spreads the riskiness of any aggregate set of loans originated in a given period. Because more lenders are involved, the probability that any lender will experience a default is reduced, even if the total number of defaults and the total amount lent in any given period remain the same.
Also, because more sources of funding can be tapped, the total amount of money competing to make the mortgages originated in a period may rise. That would cause a narrowing of interest-rate spreads between such mortgages and both comparable Treasury securities and other fixed-rate instruments. This reduces the cost of mortgage borrowing to developers and others. The same spread narrowing also arises from just having more lenders competing to finance mortgage loans.
True, more parties are normally involved in producing CMBS than in making direct mortgage loans, so the total number seeking fees may be larger. Whether that offsets the spread-narrowing impact of greater competition among lenders depends upon the relative efficiency of traditional sources and securitized sources in moving funds from the initial supplier to the ultimate user. During the past few years, the securitized funding industry has become much more efficient. The most effective firms in this business are now able to supply funds at a lower all-in cost than many traditional lending sources.
Another important effect of the increased number of sources of mortgage funding is a lower probability that all current sources of mortgage finance will simultaneously withdraw from the real estate market, leaving borrowers with no place to obtain money. That happened in 1990 when financial regulators prohibited banks, savings and loans, and insurance companies from making any more real estate loans. This helped cause immense turmoil in commercial real estate markets, leading to massive defaults, work-outs and foreclosures. It also created the opportunity for public securities markets -- especially REITs and opportunity funds -- to step in and raise capital from nontraditional sources to supply real estate's pressing refinancing needs.
When such nontraditional and differently regulated capital sources as pension fund bond departments, foreign banks, foreign pension funds, opportunity funds and individual investors are willing to supply funds for mortgage-backed securities, the chance of a complete choking off of commercial real estate lending is greatly reduced. This decreases the general riskiness of real estate mortgage lending over the long run, further narrowing mortgage spreads over relevant Treasuries.
Two nagging worries This new situation contains two nagging worries, however. The first is that the originators of the mortgage loans used in CMBS will not underwrite those loans as carefully as traditional originators did. The CMBS originators do not usually hold onto their loans but sell them to a third party, whereas traditional originators like banks, insurance companies and pension funds often held them in their own portfolios. Therefore, the latter had a stronger incentive to underwrite these loans carefully in the first place. If so, the riskiness of the original loans in CMBS may be higher, not lower. This worry is partly offset by the fact that several parties underwrite loans in the CMBS process. These include the initial originator, the operator of the conduit or fund into which the loans are placed and the rating agency that places its imprimatur on the resulting CMBS. Even the buyer of the CMBS may evaluate these loans, though that is not likely if they are relying upon investment-grade ratings. Another offsetting factor is that CMBS are based upon pools of mortgages; so the default of an individual mortgage will have a smaller impact upon the holder of such securities than it would if each loan were fully held by a single capital supplier. Up to now, there is no persuasive evidence that funding through CMBS produces greater default risk than traditional funding. But recent CMBS issues have not been put to the test of a severely overbuilt market situation.
The second nagging worry concerns the fact that the final borrower will probably have much greater difficulty negotiating any change in the original mortgage when that mortgage has been securitized than when it is held by the originator or any other single major supplier. If a developer wants to expand the size of a shopping center financed with a securitized mortgage by adding to that mortgage, he or she may have trouble persuading whoever now holds that mortgage even to discuss such a change. The loan will have been put into some pool that is now held by a servicer who is not in the loan origination business at all and has no incentive to renegotiate the initial deal. Or if the developer/owner is having financial difficulty and wants to negotiate a work-out, the same problem may arise.
In the default case, the CMBS industry has invented a coping mechanism called the "special servicer." This is a financial agency willing to renegotiate terms or foreclose on defaulted loans. The latest CMBS documents provide that, in case of a default by a borrower of some mortgage in a pool, that mortgage is shifted to a "special servicer" willing and able to engage in such negotiations. How effective this arrangement will be in a period of massive defaults has yet to be tested. Firms in the CMBS industry are also trying to reduce this problem by encouraging borrowers to make shorter loans. Nevertheless, at present, this nagging worry is still a concern to many borrowers who want maximum flexibility to change the nature of their loans in today's fast-moving markets.
Conclusion By broadening the sources of mortgage funding, the use of CMBS will have great impacts upon the future financing of commercial real estate. Altogether, these impacts will benefit fund borrowers, create more competition for traditional fund suppliers and reduce the overall riskiness of supplying mortgage funds. There are still some nagging worries about these changes, but they are not enough to prevent the expansion of securitized mortgage financing in commercial markets from becoming a permanent condition there.
Anthony Downs is senior fellow at the Brookings Institution, Washington, D.C. The views in this article are those of the author and not necessarily those of officers, trustees or other staff members of the Brookings Institution.